One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine Shanghai Lujiazui Finance & Trade Zone Development Co.,Ltd. (SHSE:600663), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors' money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

How To Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd is:

2.2% = CN¥1.0b ÷ CN¥46b (Based on the trailing twelve months to September 2023).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every CN¥1 worth of equity, the company was able to earn CN¥0.02 in profit.

Does Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd Have A Good ROE?

By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd has a lower ROE than the average (5.4%) in the Real Estate industry.

Unfortunately, that's sub-optimal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 4 risks we have identified for Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd.

How Does Debt Impact ROE?

Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's Debt And Its 2.2% ROE

Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.62. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

Summary

Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to check this FREE visualization of analyst forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.